The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, May 26, 2012

Bank regulators under spotlight as a result of JP Morgan's loss

The NY Times carried an article examining the question of where were the bank regulators while JP Morgan was putting on the trading positions that ultimately lost $2+ billion.

Regular readers know from previous posts (see here, here and here) that bank regulators do not approve or disapprove of individual positions. At a minimum, it would be interfering with the allocation of capital which is suppose to be a function of the financial system.

Regulators also do not tell the market about the individual positions or the riskiness of these positions. Not commenting would be okay if the banks were required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. With this data, market participants would have the positions and could independently assess the risk.

However, without ultra transparency, regulators have a monopoly on the information needed for assessing the risk of each bank. As a result, the market is dependent on them to assess the risk and properly disclose it.

Finally, regulators try to insure that each bank has adequate capital to absorb any potential losses from its individual positions. There is a fatal flaw to this strategy. What happens if regulators underestimate the potential losses?

As market participants know, this strategy is simply gambling with financial stability.

The failure to accurately assess the risk combined with telling the market participants that risk in the financial system had been reduced by financial innovation was a primary contributor to the financial crisis.

Scores of federal regulators are stationed inside JPMorgan Chase’s Manhattan headquarters, but none of them were assigned to the powerful unit that recently disclosed a multibillion trading loss.

They are typically assigned to the departments undertaking the greatest risks, like the structured products trading desk.

Even as the chief investment office swelled in size and made increasingly large bets, regulators did not put any examiners in the unit’s offices in London or New York, according to current and former regulators who spoke only on condition of anonymity.

Senior JPMorgan executives assured the bank’s watchdogs after the financial crisis that the chief investment office, with hundreds of billions in investments, was not taking risks that would be a cause for concern, people briefed on the matter said.

Just weeks before the trading losses became public, bank officials also dismissed the worry of a senior New York Fed examiner about the mounting size of the bets, according to current Fed officials.

The lapses have raised questions about who, if anyone, was policing the chief investment office and whether regulators were sufficiently independent. Instead of putting the JPMorgan unit under regular watch, the comptroller’s office and the Fed chose to examine it periodically.

The bank pushback also suggests that JPMorgan had sway over its regulators, an influence that several said was enhanced by the bank’s charismatic chief executive, Jamie Dimon, long considered Washington’s favorite banker.

Now, as regulators scramble to determine whether the chief investment office took inappropriate risks, some former Fed officials are asking whether the investigation should be spearheaded by the New York Fed, where Mr. Dimon has a seat on the board. Some lawmakers and former regulators also have reservations about the comptroller’s office, which is investigating the trade and was the primary regulator for JPMorgan’s chief investment unit.

“The central question is why Jamie Dimon was able to so successfully convince both its regulators that there was nothing to see at the chief investment office,” said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve Bank examiner in Boston and San Francisco. “To me, it suggests that he is too close to his regulators.”

Regulators, for their part, say they cannot micromanage a bank or outlaw its risk taking and did not bow to bank pressure when assigning examiners....

This is a matter of policy.

Long before the recent trading blunder, JPMorgan had a pattern of pushing back on regulators, according to more than a dozen current and former regulators interviewed for this article. That resistance increased after Mr. Dimon steered JPMorgan through the financial crisis in better shape than virtually all its rivals.

“JPMorgan has been screaming bloody murder about not needing regulators hovering, especially in their London office,” said a former examiner embedded at the bank, adding, in reference to Mr. Dimon, “But he was trusted because he had done so well through the turmoil.”

Even now, executives at JPMorgan disagree with some regulators over how quickly the bank should unwind the soured trade, according to people briefed on the negotiations.

JPMorgan would like to be done with the bad bet that has resulted in at least $3 billion in losses already, but senior executives argue it is a delicate process, especially as traders and hedge funds on the opposite side of the trade seize on the fact that JPMorgan is under pressure to exit the position.

Senior staff members at the Federal Reserve want the bank out of the position “yesterday,” according to a regulator privy to the discussions who insisted on anonymity because the talks are private....

Regulators would like the bank to be out of the position because it shines a bright spotlight on what regulators do and don't do.

Current and former regulators said that lower-level officials at JPMorgan had at times tried to undermine their supervision of the bank. JPMorgan has a reputation for challenging regulators more forcefully than rival banks like Citigroup and Goldman Sachs, former New York Fed officials said.

Long before the recent trade, an embedded examiner said he had asked for JPMorgan’s three- to five-year capital plan, and after waiting a couple of days was told that the bank’s management had gone over his head and “already sent it to my bosses.” By cutting out lower-level regulators, the bank officials telegraphed a message that those concerns were irrelevant, the former examiner said....

Your humble blogger has previously discussed exactly this problem of the bankers undermining supervision by making their case to the senior regulators.

The Nyberg Report on the Irish financial crisis sited this practice as one of the reasons that even when the risk of the real estate bubble was properly assessed senior regulators dismissed the assessment.

This is one of the reasons that the regulatory information monopoly must be ended and banks required to provide ultra transparency. It is only with ultra transparency that market participants can assess for themselves what is really going on.

The Office of the Comptroller of the Currency is also facing scrutiny about whether it is too cozy with the banks it oversees.

At JPMorgan, when media reports surfaced that the bank was making aggressive bets on credit derivatives, comptroller officials began taking a closer look, people briefed on the matter said.

After thumbing through the bank’s own projections for the related risks in early April, the people said, the examiners pushed for more answers but saw no immediate need to change course. The agency notes that it does not bless specific trades.

Recall, it is not the regulator's role to interfere in the capital allocation process.

This simply confirms why banks must be required to provide ultra transparency.

1 comment:

Anonymous
said...

The corollary to regulators underestimating potential losses it that they may overestimate the bank's capital, especially if it is determined by adding up asset levels during periods of regulatory forebearance.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.